WE VALUE HEALTHCARE

Strategic Transaction Trends and Valuation Issues facing Hospitals

Jon O’SullivanSenior Partner

July 2010

Aaron MurskiSenior Manager

Current Hospital Transactions

Impact of Health Reform on Transactions

Practice Acquisitions and Valuations

Ancillary Service Acquisitions and Valuations

Physician Service Agreements and Valuation Methods

Hospital Valuations

Impact of Health Reform

Affordable Care Act

Accountable Care Organizations

Bundled Payments, Episode Based payments

Measuring Quality

32 million more Medicare and Medicaid enrollees in 2014

Shortage of 125,000 physicians by 2025

Reverse outflow of service lines

Cuts in Dispro payments

Decreasing Margins

Significant Restructuring

What many hospital CEOs are thinking about

Develop an IDN

Employ physicians

Acquire practices

Acquire ancillaries

Structure quality measures

Merge/Acquire Hospitals

Impact of Health Reform

Plus:

Total spending to grow from 16% to 25% of GDP by 2025

Poor history of projecting actual costs of programs

Impact of Health Reform

Current estimated healthcare spending is unsustainable

Many physicians will struggle

20-25% of hospitals will fail

Changes to Medicare benefits- change in enrollment age?- income testing?- means testing?- limit access?

Certain hospitals/physicians will opt out of Medicare/Medicaid

Significant cuts/restructuring will be required

Hospitals will acquire more practices and employ

Acquired by larger systems or funded directly by government

Affluent moving to private plans and seek higher quality doctors and hospitals. Hospitals will restructure to meet these needs

Two tier system evolves withconsolidation of top tier providers

The progression of change:

Impact of Health Reform

Public Funded

Tax exempt hospitals will be required to take Medicare/Medicaid plans

Reimbursement will be cut to the lowest level

Certain hospitals struggle to offer new delivery models for government plans

At risk hospitals will require direct government support

Increased employment of physicians into public systems

Private Funded

Affluent consumers will pay more for access

Systems offer separate services for nonpublic payers

Consolidation/acquisitions of top tier independent hospitals to meet demand from private payers

Increased number of physicians opt out of Medicare and Medicaid

Likely Result: A bifurcated system

Physician Practice Acquisitions

Physician Practice Acquisitions

Greater desire/need to become employed

General anxiety among physicians about the future

Reimbursement cuts in specific specialties (Cardiology)

Scheduled cut of 21% of Medicare Physician Fee Schedule

Cuts in technical fees related to in-office ancillary services

Physician Supply Forecast

Physician Practice Acquisitions

Shortage estimated at 125,000 by 2025, largest in Medical Specialists

Physician Practice Trends

Private Practice 72%

Institutions 28%

Owned Practice:1997 2007

PCP 54% 49%

Med Spec 58% 45%

Surgeons 76% 65%

Physician Practice Acquisitions

60 percent plan staff layoffs

46 percent plan to eliminate service lines

17 percent will stop accepting Medicare

39 percent are considering integration (sale and employment) into a hospital system

(American Academy of Cardiology)

Example: The Impact on CardiologyProfessional cuts range from 10-40% over four years

Ancillary (Nuclear studies) cut by 40%

Elimination of consultation codes

Physician Practice Acquisitions

Fair Market ValueCompensation

Fair Market Valueof the

Practice

- Compensation must be supported by the market- Historical/future results can support higher comp- Compensation is correlated to practice value

- Generally value is tangible assets - To be higher, practice must have earnings- Without ROI, practice has little intangible value

Valuation process is subject to manipulation/faulty approaches

Faulty valuations are not a defense for hospitals

Recent cases have found hospitals guilty (Toumey, Arlington Mem)

Secretary of Health and Human Services announced FY 2011 Budget is expected to include historic support for anti-fraud efforts

Two Valuation Issues

Physician Practice Acquisitions

Ancillary Services Acquisitions

Ancillary Services Acquisitions

Three Legislative Actions are Impacting Physician owned Ancillary

Patient Protection and Affordable Care Act (2010)- Requires written notification to patients- Must provide a list of other providers in the area- Implemented immediately upon enactment- Applies to all Stark in-office services

Medicare Improvements for Patients and Providers Act (2008)- Advanced imaging services must be accredited by an HHS approved accreditation agency

- But be accredited by 1/1/2012

Deficit Reduction Act- Reduced outpatient imaging by as much as 30%

Reimbursement Risk Impacts Sustainability and Value

Imaging – Lower reimbursement, accreditation, utilization requirements

Surgery Centers – Out of Network and struggling centers

Radiation therapy and medical oncology

In-office Ancillaries -Nuclear Studies and PET

Why Do Hospitals Pursue these Transactions:

Valuations of ancillaries that are at risk are relatively low

Hospitals can apply their HOPD rates

Meet strategic desire to expand IDN and prepare for future contracting

Ancillary Services Acquisitions

Hospitals HaveOpportunity To Grow, Expand Market Share, and Leverage their Provider Based Rates

Ancillary Services Acquisitions

Surgery Centers

In-officeAncillaries

Hospitals Pulling Ancillary Services Back into their Networks

RadiationTherapy

Imaging Centers

Fair Market ValueCompensation

Fair Market Valueof the

Ancillary Business

Ancillary service valuations require the use of income, market and cost approached

Cost approach generally represents a floor and is disregarded if income and market approach are higher

Market approach can be hard to apply, especially given changes

Values can be low if the facility is struggling

EDITDA multiples can be anywhere from 3x-7x. Rules of thumb are dangerous

Can’t incorporate factors attributable directly to the buyer (ie. better contract rates)

Valuation Issues

Ancillary Services Acquisitions

Physician Service Agreements

Physician Service Agreements

Why are Physician Service Agreements Increasing

Hospitals are looking for alternatives to outpatient JVs

Hospitals desire to preserve provider based revenue streams

Hospitals have more difficulty in providing for specialty coverage for their emergency rooms

Physicians interested in participating in inpatient activities where they can add value and generate additional income

Hospitals and physicians must learn to measure, manage, and improve quality in anticipation of bundled reimbursement/global payments, episode based payments and other forms of capitation

Physician Service Agreements

Co-Management and Quality Incentive Agreements

Part 1 - Base Management Fee

Fair Market Value hourly rate

Provides for identified services where physician spends time on the process

Part 2- Quality Incentive Bonus

Follows CMS guidelines for paying for quality

Based on meeting, beating, and maintaining predetermined benchmarks

Benchmark against 6-12 quality measures

Requires Fair Market Value opinion

Hospital Transactions

Hospital Valuations

Historical Hospital Transactions

$74.3 Billion in transaction between 2000 and 2009

HCA LBO $33 Billion

CHS purchase of Triad Hospitals $6.8 billion

Excluding HCA, Triad Hospitals, and Quorum: $34.5 billion in transactions between 2000 and 2009. Average of $58 million per facility

Future transactions will fall into two distinct categories: Healthy and Troubled

Healthy hospitals Trade on EBITDA Multiples (6-8x) or Revenue Multiples (.8-1.2x)

Troubled hospitals typically trade on Revenue Multiples (.3-.6x)

SummaryHealthcare Reform will significantly alter the US Healthcare landscape and result in increased transaction activity

Current projected costs are unsustainable and indicate future significant adjustments will be required

Necessity to cut costs, limit access, reduce benefits will result in a market response

Struggling physicians and dissatisfaction with private practice will result in higher institutional employment by physicians

Hospitals will compete for high margin/high volume referring physicians

Hospitals will expand their IDNs by buying struggling outpatient ancillary service business, recouping previously lost service line business

To preserve revenue streams and learn to adjust to alternative reimbursement environments, hospitals will expand new service relationships with key physicians in specific services lines

The process will be slow and painful as hospitals make many missteps